As demand recovers after Brazil’s first recession since 2003—helped by public spending, tax cuts and lower borrowing costs—investment in new capacity rebounded too slowly to guarantee near-term supply, according to Morgan Stanley and Credit Agricole SA. Quickening inflation and rising interest rates may slow gains in the benchmark Bovespa index from 82% this year to less than 30% in 2010, Morgan Stanley said.

“We have a lot of catching up to do,” Vladimir Caramaschi, Brazil strategist at Credit Agricole, France’s biggest bank by branches, said in an interview from Sao Paulo. “Investment is just not going to be enough to meet demand.” Brazil, historically a laggard in investment in factories, machinery and other fixed capital, hasn’t changed course even as it recovers faster than most from the global recession. “The so-called Brazil cost of taxes, bureaucracy, labour laws and interest rates that remain the highest among G-20 economies discourages investment,” Caramaschi said.

The Brazilian economy is “doing well”, Nobel Prize-winning economist Paul Krugman, 56, told journalists in SaoPaulo December 2. “It’s not the same as to say it will become the economic superpower next year. The markets are reacting as if it will.”

Brazil’s real is up 34% against the dollar this year, the biggest advance among the world’s 16 major currencies, and the Bovespa index has outperformed benchmark measures in all of the 10 largest stock markets except China, according to data compiled by Bloomberg.

Krugman said he plans to sell some of his Brazilian assets because he is concerned that the gains aren’t sustainable.

Investment accounted for 19% of Brazil’s economy last year, the most since the national statistics agency began tracking the data in 2000. That compares with the 41.8% investment rate of developing economies in Asia, led by China, and the world average of 24%, according to the International Monetary Fund.

In the second quarter, Brazil, the world’s eighth-biggest economy, invested 15.7% of GDP. Caramaschi estimates the rate advanced to “a still very low” 16.5% in the third quarter.

The investment data will be released on December 10. The economy grew 2% in the third quarter from the previous quarter, when it expanded 1.9%, according to a Bloomberg survey of 30 analysts.